Small Cap Report (5 Mar) - CUP, FOUR, BREE, MACF, JSG, ISG, ZTF

Pre 8 a.m. comments

Regular readers will know that I don't like Cupid (LON:CUP) at all, based on evidence online (try Googling for customer reviews of some of their biggest brand names) of their operations apparently being less than ethical. This was reinforced by a recent BBC Radio Five Live expose of Cupid's modus operandi, which can be listened to here, and specifically names Cupid plc.

I cannot see anything in their results narrative which addresses these concerns, other than rather vague statements that, "...it is important for the Company to have a medium term goal of improved quality in the eyes of the consumer ... we believe this will cost an additional £2m in brand building marketing across several of our key profit generating markets ...". Hmmmm.

The figures themselves (for the year ended 31 Dec 2012) look very good, with revenues up 51%, adjusted EBITDA up 45%, cash having almost doubled to £14.1m, and the final dividend raised to 3p. All good stuff, but if this is being achieved by misleading customers, as the BBC allege, then it cannot have a very long shelf life. Therefore a very low PER is fully justified.

I believe that Director share transactions often give you the best indication of what management really think about a business, and the Director share sales at Cupid from the Stockopedia table (last item on the menu under "Accounts" on the StockReport) says it all - over £30m banked in Director sales in the last two years!

Follow the money is my view, and the most knowledgeable money has been getting out.

Post 8 a.m. comments

Impressive results have been issued today by 4imprint (LON:FOUR), with underlying EPS up 29% to 28.3p, which seems way ahead of broker consensus of the 22.4p and 22.9p that are shown on Stockopedia and a competitor website for year ended 31 Dec 2012. The difficulty is knowing whether the EPS forecasts have been calculated on the same basis as the adjusted reported EPS figure, which I simply don't know.

Another way of checking whether actual is better than forecast, is to look at the actual EPS growth, which in this case is +29% against +21% shown on Stockopedia forecasts, so it would appear to be a comfortable beat against forecast.

At 385p it seems to me that the price is probably about right, on a PER of about 14 times 2012 earnings.

FOUR also pays a fairly decent dividend, which has been raised to 15.45p for the year. It had net cash of £10.7m at the year end, so all seems to be going well. It looks as if their main area of activity is North America.

I'm getting increasingly perplexed at the very stretched valuations being paid for high growth companies at the moment. The old Jim Slater PEG system is quite a useful rule of thumb, i.e. that the annual rate of earnings growth as a percentage can be substituted for the PER to decide if you're paying a sensible price or not. So a company that is growing its earnings by 20% p.a. could be considered fairly price if it was rated on a PER of 20.

What I've noticed in recent weeks is that shares which would have been on a PER of 15-20 are now soaring up to ratings in the twenties, or even thirties. A good example is Delcam (LON:DLC). Great company, which I've followed for years, but it looked fully valued at around 1000p/share. It's since shot up to 1400p/share, putting it on a pretty warm PER.

It's the same with LOQ, which friends of mine hold, and have been proven very right about, but a PER of over 30 is looking extremely generous now. I'm told that it's being driven by very strong Institutional demand, who are now prepared to pay aggressive valuations for growth businesses. So maybe I need to recalibrate my idea of what fair value is? On the other hand, I'd rather play it safe, and stick to more pedestrian valuations where good companies are available cheap because of temporary negative sentiment (e.g. Vianet, where you can now lock in a 6% dividend yield, because of a recent disappointment on timing of contract wins, etc).

To my mind it's a percentages game - so why buy (or hold) something which is already fully valued (or over-valued), when there is so little upside percentage gain potential to be had? That only makes sense if you keep your finger permanently hovering over the sell button, and exit on a hair trigger. But I suspect lots of people are thinking along the same lines, just running with the momentum and hoping to sell at the top when it turns. Some of these stretched valuations could fall a considerable amount, very quickly, once sentiment turns. So it's always important not to be the one holding the parcel when the music stops.

Top-slicing is a great strategy I think - i.e. selling 10-20% of a position after it's had a big run upwards in price, as you thereby lock in some gains, but still have exposure to further upside.

It's not as if we're in a buoyant economy either, so companies which are growing earnings by 20% this year may struggle to follow that with another 20% next year or the year after. Hence stretched valuations make even less sense, unless you are highly optimistic about the macro economic picture? Or the company has some niche which you think they can continue exploiting with no worries about competition appearing.

These are all warning signs to me, that markets might be over-heating somewhat, and I've been cutting back on positions lately which have gone up a lot, just to lock in some gains. It's always dangerous to become over-exuberant in bull phases, so I hope readers are being careful.

Breedon Aggregates (LON:BREE) reports a strong set of results, despite market conditions in construction in 2012 being, "the worst trading conditions I can remember in my 50 years in this industry", as Peter Tom, their Executive Chairman reports today.

Revenue is up 3% to £174m, and underlying operating profit rose 55% to £8.8m.

However, it doesn't pay a dividend, and looks to have net debt which is far higher than I would be comfortable with as an investor, which rules it out for me.

The market doesn't seem to like 2012 results from Macfarlane (LON:MACF), as the shares have dropped 8% to 25p this morning. The problems here have always been net debt (reduced to £6.8m) and a whacking great pension deficit (reduced slightly to £18.9m). These are material figures compared with a market cap of about £30m.

My problem with pension deficits is that the deficit shown on the balance sheet can often be seriously understated compared with the much larger deficit used to calculate overpayments. So it's a real minefield for investors, and each pension deficit needs to be considered carefully on the specific facts for that case.

The dividend is attractive however, with 1.55p total for the year, giving an excellent yield that must be around 6%. Management state their intention to maintain the dividend, but that looks a tight squeeze to me considering they also have to reduce debt, and pay £2.5m into the pension fund in 2013.

On the more positive side, I like that they are seeing some growth by targeting growth markets, such as protective packaging for internet retailers. On balance, I always come to the same conclusion with Macfarlane - too messy to be considered as an investment, although this is probably the closest I've ever come to seriously considering it - on the basis that rising interest rates on Gilts should trigger a partial reversal of the increased pension deficit.

Results from Johnson Service (LON:JSG) do not appeal to me, because they still have a weak balance sheet with far too much debt, seem to be endlessly restructuring, and there's the added complication of a pension deficit too. It just doesn't look good value to me, once you adjust for debt. Adjusted, fully diluted EPS for 2012 came out at 5p. So at 43p the shares are on a PER just under 9. That's fine, until you factor in that net debt works out at around 23p/share. Also they are having to make payments of £1.9m p.a. to reduce the pension deficit. So if anything it looks fully, or even over-priced to me.

It's difficult to say anything meaningful about the accounts from Interior Services (LON:ISG), since their profit margin is so tiny as to make analysis of the figures pretty meaningless. Underlying profit before tax was £3.8m on turnover of £659m! So a margin of not much more than half a percent. So what happens if something goes wrong with a contract, and cost over-runs? As we saw with Severfield-Rowen (LON:SFR), once you lose control of big contracts, the very existence of the company hangs in the balance.

For me the cut-off point where it simply becomes too risky to invest in any company is where they make a profit margin of less than about 3% of turnover. Below that, and the swings in profitability from one year to another can become too extreme, and the risk of something going wrong becomes too great.

I've had a quick look at results from Zotefoams (LON:ZTF), which look OK. EPS is up slightly to 12.1p, so at 197p the shares don't look good value to me. The balance sheet is sound, and there is a 2.7% dividend however, so if you like the company's long-term prospects, then great. I don't know enough about the company to judge its prospects.

As a further aside, I'm struck by how it's the larger groups reporting 31 Dec results first. Yet these are the largest & most complicated groups. Surely it should be smaller companies rushing to get their much simpler accounts out promptly? These days a good Finance Director should run the accounts close to being on a real-time basis. I managed to get the 31 Jan year end results audited & published within 6 weeks of the year-end back in the 1990s, when I ran the finances of a ladies wear group with about 150 branches, and about a dozen limited companies. So with advances in technology, it's very difficult to justify why it takes smaller Listed companies so long to issue their accounts. There's no problem with booking auditors either - if you're organised, they welcome the chance to get them done & dusted nice and early.

So here's a plea to smaller Listed companies - how about demonstrating your grip over your finances by issuing more timely financial information to shareholders. Having to wait until mid-March 2013 to see accounts for 2012 strikes me as pretty shoddy. They should be available in early Feb for relatively small companies.

See you same time tomorrow. I publish the first section just before 8 a.m., then updates are published for each company mentioned over the next couple of hours. So it's always worth checking back if you're an early bird. The finished report is usually done by about 10:15 a.m., once I've irioned out the typos & formatting.

Regards, Paul.

(of the companies mentioned today, Paul holds a long position in Vianet, and no short positions)

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Castle Street Investments plc, formerly Cupid plc, is a United Kingdom-based investing company. The Company focuses on identifying and exploiting future investment opportunities. The Company seeks to invest in a range of investments or in just one investment, which may be deemed to be a reverse takeover. more »

4imprint Group plc is a direct marketer of products in the United States, Canada, the United Kingdom and Ireland. The Company supplies products under the brand name 4imprint. The Company sells a range of promotional products, which are purchased by a range of individuals within various types and sizes of businesses and organizations. These products have a range of uses as an integral part of sales and marketing activities; recruitment and recognition schemes; health and safety programs; and other initiatives to make a connection between the customer's organization and the recipient. Its promotional products consist of basic giveaways, such as pens, bags and drinkware to more exclusive products, such as embroidered clothing, business gifts and full color trade show displays. The Company's subsidiaries, 4imprint Inc. and 4imprint Direct Marketing Limited, are engaged in direct marketing activities. more »

Breedon Aggregates Limited is a United Kingdom-based aggregates company. The principal activities of the business are quarrying of aggregates and the production of added value products, including asphalt and ready-mixed concrete, collectively known as aggregates, together with related activities in Great Britain and Jersey. The Company has two operating segments: England and Scotland. The England segments operates 15 quarries, nine asphalt plants and 23 ready-mixed concrete and mortar plants, serving the East & West Midlands and East Anglia, Wales, Greater Manchester and South Yorkshire. Its English surfacing contracting business undertakes road surfacing projects, as well as infrastructure contracts. The Scotland segment operates 38 quarries, 18 asphalt plants, 37 ready-mixed concrete plants and two concrete block plants, primarily supplying the north, west and east of Scotland, including the Hebrides. more »

As you say, some fund managers and many retail investors are currently prepared to pay big premiums for go-go growth stories. Whilst some of those may pay off big time, as we know, the majority will disappoint - and then investors face the double whammy of lower earnings and a lower rating. Moreover, should the current bullishness evaporate, then so could buyers and these elevated ratings could tumble.

OTOH IMO valuations for many slightly more pedestrian companies remain at historically low levels. Take Braemar Shipping Services (LON:BMS) and ICAP (LON:IAP) , for example - both sound, cash generative, businesses with good track records (though suffering a bit from recessionary factors) offering yields above 6% - and both likely to benefit from any economic recovery. Is it really right for such businesses to trade on P/Es below 10?

There has definitely been a derating of such businesses since 2008 and their ratings have a long way to go to recover to pre-recession levels. I'd rather have that "double whammy" working in my favour - rising earnings and a higher rating, than the reverse.

Following fashionable shares to toppy valuations nearly always ends in tears, unless you play the game for what it is, and manage to time your exit well. All too often though, I think people fall in love with the share, convince themselves that a toppy rating is justified, and hold all the way down, in denial. I know because I've done it myself!!!

One thing I think is best kept in mind regarding p/e ratios and GARP is that sometimes a p/e can look very high e.g. 100x but in absolute terms the profit can be quite small because the business is just turning into profit. This is best explained by an example.

Suppose company A has a p/e of 100 and is earning £1m with a market cap of £100m and company B has earnings of £50K and a market cap £5m also with a p/e of 100. Both operate in high growth new areas of the economy but the latter is obviously much more early stage.

It's pretty obvious to see that company B could grow earnings to £500K without much trouble reducing p/e to 10 by squeezing another £450K of profits whereas A has to grow by £9m.

This is all very obvious stuff but one needs to bare in mind what the eventual size of the market might be the company operates in and how far along the growth curve they are what sort of competition there is etc. when deciding how "expensive" a p/e rates a stock,.

Does the market and individual shares ever truly reflect what may be seen as "fair" value? That's surely why you have value investing, growth investing, momentum investing or trading, etc. You are always likely to have to pay more for companies that are perceived by the market to be growth prospects or have strong momentum and their valuations are likely to remain stretched until market sentiment towards them changes. This might be because sentiment has shifted about the company itself from one of being a growth prospect to one that should actually be producing growth and is now seen as more mature. Alternatively, in a bear market or the various cycles that some sectors go through we will often see under valuation of what may be good companies because of sentiment changes.

If it is a bull market then I would have thought that it will be increasingly difficult to find "value", if by value you really want things to be cheaper, but often things get cheap for a reason. This may be due to a market sentiment that you see as wrong, but value investing is often about taking the other side of market sentiment and then hoping that it eventually comes around to your way of thinking. Sometimes it can be a long wait.

Interesting. If you were a fund manager, would you want any Cupid shares on your list of investee companies going out to your fund holders, given the widespread publicity about their apparently unethical (according to the BBC) way of operating, with such unconvincing, almost non-existent rebuttals from the company itself?

We all know that companies reply to allegations with weasel words from PR people, but in this case they barely even denied anything.

I once invested in an unethical company called Invox, when it was on a PER of 3.5, thinking it couldn't go any lower, and believing all the reassurances from the Directors. Funnily enough, there was a big Director sale there too, which was reassuringly explained away. It didn't end well, these things rarely do.

Good luck to anyone who touches Cupid, I think it stinks, based on the BBC reports of unethical conduct, terrible Google reviews from hundreds of people, and the massive Director selling of shares.

Paul trained as an accountant, then spent 8 years as FD for a ladieswear retail chain.He became a professional small caps investor in 2002 to date.Paul writes a small caps report for Stockopedia.com on weekday mornings. He joined Fundamental Asset Management Ltd as a research associate in 2014, as part of their Small Cap Value Portfolio team. more »